How To Make Pensions Less Burdensome For The Government?
The expenditure burden of government pensions is becoming a ticking time bomb, and the demographic transition – the ageing of the population due to declining fertility and increasing life-expectancy – is not going to help in the long run. According to a thesis done at PIDE, it is estimated that pension expenditures are expected to rise from about 1% of GDP to 3.5% of GDP in the long run due to the demographic transition. In a country already facing fiscal imbalances, the situation requires serious thought and action.
The youth bulge in Pakistan – people below 30 constituting 64% of the population – is often discussed, but the population’s ageing is overlooked. The ageing is expected to cause a decline in the projected labour force. The consequences are serious for economic growth and fiscal sustainability, mainly because the ageing is likely to result in an increasing number of pensioners.
Currently, Pakistan’s youth bulge offers the potential of a demographic dividend. However, this bulge will eventually enter unproductive ages, adding an economic burden if not managed properly. The issue is how to improve or at least maintain the standard of living of the old age population through pension and social security schemes
Government expenditures, including pensions, are primarily funded from taxes paid by the working population. In Pakistan, the public sector pension system is such that the current working population is taxed to pay for retirees’ pensions, known as the pay-as-you-go (PAYG) pension system. However, as the population will age, fewer workers will have to bear the burden of a larger old population due to the increasing old-age dependency ratio. This will make the PAYG system unsustainable.
An alternative to the PAYG system is a fully funded pension system in which the workers contribute a particular amount from their income, which is invested on their behalf. The returns from that investment plus workers’ own contributions are then given to the workers upon retirement.
Since the ageing will result in the rising proportion of pensioners in the population, under the PAYG system, the workers in the future will have to be taxed more than today to provide for the pension of the pensioners. Hence the PAYG system is bound to become fiscally unsustainable, necessitating a transition from the PAYG to a fully funded pension system.
In a fully funded system pension expenditures are borne by the workers from their own contribution while they are working. A tiny portion of salary is deducted as a pension contribution. The amount is invested on behalf of individuals, and pension benefits are provided from the accumulated amount – contributions plus return on investment. It is worth reemphasizing that amount that a retiree would get upon retirement would be the sum of own periodic contributions plus the return on investment. In times of high interest rates banks even do offer to double depositors’ money in five years, if invested for a long term, the contributions from employees are not expected to be too large, because the pension funds will remain invested for a longer term.
The transition from the PAYG system to a fully funded pension system involves cost because the government will have to bear pension expenditures of already retired workers, to whom the government had made generous promises when they were working. However, the transition cost is rising with time because the retired population’s proportion is increasing with time. So, this cost must be considered temporary, and in any case, this cost will be much lesser than what the government is bearing now by paying for all pensioners through PAYG.
There is not all gloom and doom, however. There are ways to improve the situation. One is to increase female labour force participation. Due to the low female labour force participation rate in Pakistan, the situation does not look too bright. Similarly, the adoption of technology and innovation can increase the employed labour force’s productivity. An improvement in these factors will positively impact the overall labour force and economic growth. Special attention to these factors will also weaken the negative impacts of the ageing on output. Furthermore, if enough savings and investment are made during the working ages, the issue of financing the elderly can be sorted. Based on those savings, there is now talk of even a “second demographic dividend”. The first demographic dividend, for that matter, is based on the income generated by the working ages.
To quantify the costs of ageing and a possible move from the PAYG system to a fully funded one, a detailed study is needed that explores the transition from the PAYG system to a fully funded pension system. Costs associated with ageing also need to be explored. Other fiscal responsibilities that are affected by the ageing transition must also be investigated, including health expenditures and social security schemes for the elderly population.
The fully funded pension system besides reducing the fiscal burden of the government also entails other benefits for the economy. Savings are crucial for the growth of any economy – the forced savings that the fully funded pension system will generate when deposited in banks or invested in securities through the stock exchange, will provide the much-needed funds for the entrepreneurial activities through loans and investments.
The writer is a researcher at PIDE. He can be reached at [email protected]